Vanguard Canada Gets a Six-Month Checkup

It’s now been a year since Vanguard set up shop in Canada, and just over six months since their ETFs began trading on the Toronto Stock Exchange. This week I had an opportunity to chat with Atul Tiwari, the affable managing director of Vanguard Investments Canada, about the company’s experience so far, and what we can expect in the future.

During their first six months, the Vanguard ETFs have gathered $230 million in assets under management. “I think we’re on track,” Tiwari said when I asked whether he’d expected that number to be higher. “We recognize there is a lot of competition in the market. Certainly mutual funds—although they are not growing to the same extent as ETFs—are still a formidable competitor that we’re up against.”

Vanguard is certainly competing in a difficult space. While it’s true that ETFs are attracting more and more dollars, much of that growth is driven by narrowly focused products. (The BMO Covered Call Canadian Banks ETF has attracted an astounding $758 million in its first 18 months.) But Vanguard has always stuck to broad-based, plain vanilla funds designed for long-term investors, and that means they have to contend with some powerful inertia.

More focus on retail investors?

So far Vanguard has put all of its marketing efforts toward encouraging advisers to use its ETFs. I asked Tiwari whether the company would begin targeting do-it-yourself investors in the future. “In some ways, awareness about Vanguard may actually be higher [among DIY investors] then among advisers,” he said, “because a number of DIYers hold some of our US products already, so we have a head start with them.”

Tiwari said that Vanguard would consider partnering with a discount brokerage to offer commission-free ETFs. “Right now there is only one of our products on the Scotia iTtrade commission-free platform, but we are open to further discussions there, as well as with others who might be interested. We think anyone who provides greater access to ETFs through something like a commission-free trading platform is doing a good service for Canadians. We are totally open to that, and we’re constantly trying to find ways to get our message out to the DIY investor.”

New ETFs in the pipeline

One burning question for index investors is what new products we can expect from Vanguard, and when they might be launched. “We’re in that process now,” Tiwari said. “We are definitely looking at coming out with more ETFs this year: that’s the goal.” Although he wasn’t able to be specific, he confirmed that the next tranche would have a Canadian focus. “The broad areas we are looking at are equity income, fixed income, and some of the sectors.”

That likely means a Canadian dividend ETF and one or more corporate bond ETFs, perhaps one short-term and one more broad-based. As for sectors, the market could certainly use a Canadian REIT fund that is less expensive than the ones already available from iShares and BMO, which are both around 0.60%. Financials, energy and materials are the other obvious candidates—all of the other sectors are awfully narrow in Canada. Moreover, I would not be surprised to see an ETF covering the mid-cap or small-cap space, since the Vanguard MSCI Canada Index ETF (VCE) holds only the largest 100 Canadian stocks.

25 Comments

Michael
June 15, 2012 at 11:58 am

@CCP May I ask a question regarding Vanguard MSCI EAFE Index ETF (CAD-hedged) (VEF) https://www.vanguardcanada.ca/documents/literature/F9325EN.pdf Document says it “Invests primarily in the U.S.-domiciled Vanguard MSCI EAFE ETF.” My concern is about withholding tax. I believe when the index companies pay the U.S. domiciled ETF dividend, foreign withholding tax applies. Now the question is when the U.S. domiciled ETF pays Canada listed VEF, will VEF subject to a US withholding tax? Will I be charged withholding tax twice holding VEF?

One quick question that you might have touched on with Atul, are there any plans for non-hedged EAFE or US funds? I know I could buy the US listed versions but then I would have to pay to convert currency to US$ (I think it’s 1.5% each way for Qtrade?).

Not that they asked my opinion, but as I wrote about when they first announced their Canadian product lineup – they are completely wasting their time with the advisor channel. It’s not going to happen – not now, not ever. I honestly don’t know what they are thinking with that strategy.

Plain ETFs are great, but the diy investor market in Canada is too small to make much money off of when you are late to the party (as they are).

The area that Vanguard can fill is the same one they already fill in the US which is to offer cheap index mutual funds and some service to go along with that. Ie someone can call them and get some basic advice on what kind of portfolio to set up.

As you know, index mutual funds are a lot easier to deal with than ETFs – that’s where most of the new “semi-DIY” investors will be.

@James: I have asked Vanguard about this in the past, and they’ve said it is certainly a possibility. But I don’t expect it to be a priority in the near future. As you say, investors can already buy the US-listed funds, albeit with the added cost of currency conversion in many cases. Note that iShares has hedged XSP for seven years now and has never added an unhedged version. I would expect it to happen only if the US dollar gets very strong and investors demand it.

@Mike: I share the same wish for direct-sold mutual funds, and I asked them about this back when the ETFs launched. They have obviously done a lot of market research and they’ve concluded that ETFs are where the growth is today. The sad fact is that the public and the financial media have adopted the simplistic notion that ETFs are good and mutual funds are bad. They miss the subtlety that the problem is high costs and poor active management, not the structure of the products.

That’s not to say they won’t eventually go that route: they offer both mutual funds and ETFs in the UK and Australia. Let’s remember that it’s been just six months. To their credit, Vanguard has a history of rolling things out slowly and deliberately to make sure they get things right.

Park
June 16, 2012 at 9:36 am

What I would like are some truly Canadian domiciled ETFs that cover foreign stocks outside the USA. Foreign countries commonly withhold tax on dividends. With Canadian domiciled ETFs, one can get foreign tax credit for the withholding taxes. With the wrap ETFs that Vanguard Canada is selling, you will only be able to recover the withholding taxes on American stocks. Vanguard Canada might counter that one needs sufficient assets to justify truly Canadian domiciled ETFs. But TD eseries and CIBC offer such products, and some of their mutual funds don’t have large asset bases.

The second request on my wish list is ETFs without currency hedging. Canadian Capitalist has written some good posts on this subject. For those intending to hold ETFs for the long term, the purpose of currency hedging eludes me. The effective cost of hedging is usually considerably higher than what it looks on paper. A selling feature of ETFs is their low cost. But the cost of currency hedging can make a mockery of that selling feature.

Yes, one can buy their US listed ETFs, if one doesn’t want currency hedging. But there are the costs of currency conversion. And it won’t change the above mentioned problem regarding inability to recover nonAmerican withholding taxes. By buying US listed ETFs, there is the possibility of estate tax. At present, that is a nonissue for almost everyone. But will it be in 25 years?

By owning foreign listed ETFs, there is increased complexity and risk. That complexity and risk may manifest itself in the future, in ways that can’t be predicted. Congress, the IRS and the SEC will look out for the interests of Americans first, not Canadians.

I can give you a story on a personal level, to make this more relevant. I worked for a period of time in the USA, and bought Vanguard mutual funds while I was there. I moved back to Canada, and some time after I came back, I got a letter from Vanguard. The letter stated that I could withdraw my mutual funds, but I could no longer exchange between mutual funds. In my open account, that resulted in me repatriating it to Canada. However, I also had money in an IRA (American equivalent of an RRSP). That money couldn’t be repatriated to Canada. Fortunately, TD Ameritrade would allow me to transfer my IRA and would also let me trade in that IRA. However, there is always the possibility that TD Ameritrade will be sending me a letter, similar to Vanguard’s, sometime in the future.

“But Vanguard has always stuck to broad-based, plain vanilla funds designed for long-term investors, and that means they have to contend with some powerful inertia.”

The above statement is true, when it comes to American investors. And IMO, such broad based plain vanilla funds are all that at least 95% of retail investors need. But when it comes to Canadian investors, that statement is false.

What would I like Vanguard to do? Sell a noncurrency hedged version of VTI, which results in almost total exposure to the US stock market. Sell a noncurrency hedged truly Canadian domiciled version of Total International Stock ETF, that gives exposure to 6400 stocks outside the USA. EAFE and Emerging Market ETFs give exposure to only 1800 stocks. If Vanguard did that, the above statement would be true.

I have been critical of Vanguard, but the same criticisms apply to iShares

Park
June 16, 2012 at 9:42 am

Claymore offered currency hedged and noncurrency hedged versions of the same fundamental ETFs. iShares inherited those ETFs, and at least so far, has continued to offer both versions. Why can’t this be done for other ETFs?

I’m with Park – there is a market for more international ETFs available in Canada.

Goldman Sachs just published this paper that summarizes the ETF market and talks about why market dynamics may be leading index ETFs to generate negative alpha if used as a hedge.
Even if you would not do this it is an interesting short paper that has investment takeaways because it talks about how correlated sectors are over time within ETF structures. So if there are new products from Vanguard that divide the market by sectors in any way this paper could be useful in putting them in perspective.

@Park: I agree that in an ideal world we would have access to truly Canadian-domiciled ETFs with full access to foreign markets. But I think we need to recognize the practical constraints here. VTI holds about 3,300 stocks, while VXUS holds about twice as many. There is simply no way that any fund can replicate those indexes efficiently without billions of dollars in assets, and that will never happen in Canada. VTI holds $180 billion in assets, which is about five times larger than the entire Canadian ETF industry.

Buying Vanguard’s US-listed ETFs is still a pretty great option. While it’s true that currency conversion can be costly, there are ways to minimize it (using Norbert’s gambit), and once you do that you can get access to about 10,000 foreign equities for an annual cost of about 10 or 12 basis points. I think we take for granted that not so long ago that would have been absolutely unheard of.

That said, it would presumably be a simple matter to offer unhedged versions of VUS and VEF. But again, give it time. Remember that most Canadians clearly prefer currency hedging, so it made sense for Vanguard to start there. It’s been just six months: the ETF lineup will expand.

Park
June 16, 2012 at 10:40 am

If Claymore could offer hedged and unhedged versions of the same ETF, and iShares continues to do so with the same ETFs, why can’t this practice be adopted by other ETFs?

About the Total International Stock ETF and its 6400 stocks, it may be true that the Canadian market is too small for that. But why not have Canadian domiciled nonhedged versions of EAFE and Emerging Markets funds? If TD and CIBC can do it, Vanguard (the world leader in indexing?) should be able to.

Most Canadians may clearly prefer currency hedging; however, if they understood the true cost of hedging, I doubt they would. There have been those, who have tried to educate Canadians on this topic; Canadian Capitalist comes to mind. It would be an exaggeration to say that the true cost of currency hedging has been kept a secret from Canadian investors. But there is an element of truth to that statement.

“But Vanguard has always stuck to broad-based, plain vanilla funds designed for long-term investors, and that means they have to contend with some powerful inertia.”

iShares XIC has 253 Canadian stocks in it. Vanguard’s Canadian stock ETF has 100 stocks in it. iShares has the broad-based fund, not Vanguard.

Your statement about giving Vanguard time is reasonable. But the hints from Mr. Tiwari are not in the direction of broad-based plain vanilla funds.

@Park: I stress that agree with your wish list completely: I just want to make sure investors have realistic expectations.

An S&P 500 fund would be pretty doable even with a small asset base, but a VTI clone would be very tough with its thousands of small-cap stocks. The EAFE index contains almost 1,000 stocks in two dozen countries and is also quite difficult to replicate. I recently spoke with a fund provider who told me this first-hand. Note that VEM (Vanguard’s emerging markets fund) is unhedged.

Remember that all of the trading costs required to buy a portfolio of hundreds or thousands of stocks get passed along to the investor. So even in Vanguard tried to this and stuck to a low MER, the funds would almost certainly have large tracking errors until they built sufficient economies of scale. These tracking errors would probably exceed the costs involved in buying the ultra-efficient US-listed versions.

About US stocks, the ETF doesn’t have to be Canadian domiciled; the present wrap version of VTI (VUS) is fine. Except VUS is currency hedged.

DFA International Core Equity Fund provides exposure to 4350 stocks outside Canada and the USA. Hedged and nonhedged versions are available. From what I understand, it is truly Canadian domiciled, so there is better tax efficiency than the wrap funds or the US domiciled funds. It has an MER of 0.63%. It has assets of around $460 million, but when it started in June 2005, it would have been much smaller. So it can be done, although I’m not saying it would be easy.

With the 1800 stocks of EAFE and Emerging Markets combined, if TD (EAFE only) and CIBC (EAFE and Emerging Markets) can offer noncurrency hedged Canadian domiciled funds, why can’t Vanguard or iShares?

Habsfan
June 16, 2012 at 2:01 pm

I was wondering if there is any risk of Vanguard Canada going belly-up or closing shop? More specifically, I was wondering what would happen if I own VCE, VAB or other Vanguard ETFs and they close shop, go bankrupt, etc?

Doug
June 16, 2012 at 2:29 pm

My guess is that if Vanguard Canada closed shop, then you’d have to pay the taxes on any unrealized capital gains.

Although I have been critical of Vanguard, I should add that I very much hope they succeed, and that my criticisms are equally applicable to iShares. Even if you don’t own Vanguard ETFs, you want Vanguard to succeed. Without Vanguard, the other ETF providers would probably raise their MERs.

Habsfan, your comments may unfortunately be well taken. VUS (American stocks), VEF (EAFE stocks) and VEE (Emerging Markets stocks) have assets of $39 million, $17.5 million and $42 million respectively. At 6 months, that’s not bad, but one would have expected more. Cost is paramount in index funds, and Vanguard ETFs will probably outperform their counterparts at iShares due to their cost advantage.

Incidentally, it is interesting that of the 3 Vanguard ETFs investing in foreign stocks, the one with the greatest assets is the one that isn’t currency hedged. This is despite that the fact that there is a lower cost US listed Vanguard ETF covering Emerging Markets. One hears the argument that Canadian listed ETFs have to be currency hedged; otherwise, Canadians would invest in their lower cost US listed counterparts. But the experience with VEE is not consistent with that.

@Habsfan: If an ETF is shut down, investors get a warning well ahead of time and can then choose the time to sell their position. As Doug says, they would be on the hook for any unrealized capital gains. In the event of a bankruptcy, there is no risk of investors losing their money, as mutual fund regulations require that assets must be held by a third-party custodian.

@Doug: I’m not sure your conclusion follows from your premise. Could the greater popularity of VEE not be because more investors are choosing to invest in emerging markets rather than in Europe/Japan these days? What we don’t know (and probably can’t know) is how many Canadians hold VWO. That would be a more interesting comparison.

Can’t wait to see another choice for Canadian REITs and Canadian Dividends.

Steve
June 16, 2012 at 6:20 pm

Not sure if this is gonna happen, but I’d love to see a small-cap Canadian ETF down the pipe, which is, surprisingly, very limited for index and ETF investors in Canada. The only small-cap ETF or index fund in Canada is the iShares small-cap, and its performance is underwhelming to say the least. Come on Vanguard, give us some options!

@Doug: Agree completely about the REITs. It will be interesting to see if they use a simple cap-weighted strategy: if they do, they’ll have the same problem as XRE, with RioCan making up a huge portion of the index.

@Steve: I do think we’ll see something in the mid-cap or small-cap space. But remember, these are index funds, so they’re going to be very similar to the iShares offerings in terms of holdings. If the performance of XCS has bee underwhelming, it’s because small-cap stocks have not performed well, not because there’s anything wrong with the fund.

My Own Advisor
June 17, 2012 at 9:04 pm

Nice update Dan.

I’m with Doug, I’m tired of paying 0.60% for XRE and the diversification it provides.

I’ll be curious if they come out with a product, eventually, that rivals XIC.

A competitor to XDV as you have noted would be good to see as well.

Probably some sector ETFs longer term?

BC_Doc
June 18, 2012 at 4:05 am

Great update and very interesting comments from your readers– thanks!

My thoughts:

1) I’d love to see unhedged versions of VTI, VEU, VT traded on the TSX. While these three ETFs are available via the NYSE/Norbert’s Gambit, I suspect Vanguard’s assets under management would increase by making these three ETFs (or a Canadian version) available via the TSX.

2) I’d also love to see mutual fund versions of these three ETFs available in Canada.

3) Bond ETFs: I really like the two bond ETFs (VSB and VAB). How about adding a Real Return Bond ETF to go with it? Also, if Vanguard could shave 5 basis points off the MER on VAB that would be huge. Compared to the 0.11% MER for “BND” (Total Bond Market ETF) in the US, VAB is pricey (especially in these days of record low fixed income returns).

Park
June 18, 2012 at 3:02 pm

IShares emerging markets ETF (XEM) has $228 million in assets, despite the absence of currency hedging. Once again, both iShares and Vanguard have US listed emerging markets ETFs with lower expenses than XEM. So is currency hedging critical to the success of a Canadian listed ETF investing in foreign stocks?

Park
June 28, 2012 at 12:47 am

I wasn’t intending to add another post. However, I’ve made comments critical of Vanguard and also iShares on this thread. I hadn’t looked at the BMO Covered Call Canadian Banks ETF before. This ETF is the triumph of marketing over reason. Canadian Capitalist has written some good posts on it. Why not just buy the stocks of the 7 banks comprising this ETF? If you need more income than the dividends, sell some shares. I would be very surprised if such a strategy underperformed this covered call ETF.

I realize this post is off topic. But kudos to Vanguard for not selling such a product and shame on BMO for doing so.

dale
July 1, 2012 at 8:30 am

hey Doug zwb is much different than holding the equities only. There is the income premium. I see it as an income turbo charger. If you hold any Canadian equity ulready have the banks. The generous income premium can help you lower volatility and boost return over time.

Park
July 1, 2012 at 10:40 pm

“The generous income premium can help you lower volatility and boost return over time”

Show me the evidence that a covered call strategy outperforms a long equity strategy. The best that I’ve seen for a covered call strategy is a modest outperformance over a long equity strategy; that was for equity indices and not individual equities. And such analyses ignore the effects of costs and taxes.

If the market goes sideways or down, then a covered call strategy will outperform a long equity strategy. Such a result depends on one’s ability to time the market.

Callahan
November 20, 2012 at 1:57 pm

@Park: I like DFA International Core Equity and own it… the MER is good, but you have to include the cost of the advisor fee of about 1% since DFA doesn’t sell to individual investors.